In search of safe disclosure
Before safe-harbor protection for forward-looking statements was introduced in the Private Securities Litigation Reform Act of 1995, making predictions that failed to come true often triggered nasty lawsuits. If a company missed an earnings projection, even by just a cent or two, a class-action lawsuit accusing management of lying could be filed within hours.
Congress declared that the threat of litigation had ‘muzzled corporate managements’ and forced them into producing weak and timid disclosures.
Safe-harbor protection was meant to ‘enhance market efficiency by encouraging companies to disclose forward-looking information.’ More than 13 years later, there are still questions about whether it provides any real protection. Here, Michael Charlson, a litigation partner at Hogan & Hartson in Palo Alto, California, gives his views.
Why is now a particularly good time to look at the safe harbor?
Business forecasting is always difficult, and the current downturn has made it even harder, but it’s in times of uncertainty that management’s outlook on future prospects becomes an even more important input for people making investment decisions.
Also, the SEC wants to see the financial crisis itself reflected in updated discussion of operations and risk factors, but businesses need to talk about these issues in company-specific rather than generic ways. In fact, I expect to see SEC scrutiny of financial statements and related discussions in company 10Ks and 10Qs, and I suspect we’ll see more enforcement in the area of disclosure.
What steps can a company take to improve its safe-harbor protection?
Court rulings point toward best practices to improve the chances of invoking safe-harbor protection. If there’s one takeaway, it’s that courts reject boilerplate risk disclosures. They want company-specific, substantive warnings about current risks.
A company should begin by looking at its risk disclosures in periodic filings, press releases and conference call presentations. I’ve seen big companies with risks listed in their 10K that are identical to those from five years ago. Even if those disclosures are substantive, the fact that they weren’t changed for years supports claims they’ve become boilerplate.
A company’s risk profile changes over time, and especially over this last year. Risk factors should be reviewed every quarter; then a company can parlay that review into a modification of its safe-harbor disclaimer so that it actually says something about the risks currently facing the business.
Consider how the risks are ordered and how they’re phrased, and go over them with senior management. For example, does the disclosure about competition reflect the current state of the business? Liquidity is very important in the wake of the credit crisis. A company’s business might be just fine, but if it has a $200 mn convertible debenture coming up and no one’s going to convert because the stock price is low, and this will necessitate new financing, the management discussion and analysis should say so.
It may not be fair because it is a hindsight-based inquiry, but the safe harbor tends to be successfully invoked when the specific risk factor that hit performance was included in the safe-harbor disclaimer. IROs should therefore focus on whether the risks that really keep management awake are reflected in the safe-harbor statement – vague generalities like ‘we are subject to competition’ just don’t cut it.
With a solid safe-harbor statement, is a company considered safe?
The hope is that a shareholder lawsuit would be thrown out at the motion-to-dismiss stage, before the tremendous cost of discovery and threat of liability could press even innocent companies into settlement.
Of course, good compliance in general is essential. In a lot of cases where safe-harbor protection has been rejected by the court, the allegations went beyond just missing quarterly earnings or whatever other prediction turned out, with hindsight, not to be accurate. For example, when there have also been allegations of unusual insider trading or accounting fraud, courts have been reluctant to throw a case out before investigating further.
As for regulatory risk, remember that the SEC doesn’t have to actually bring an action to advance its agenda. The burden of an SEC investigation can be substantial even if the regulator decides not to charge the company. Plus, the SEC’s Division of Corporation Finance regularly looks at risk disclosures when deciding whether to subject a company to broader review. Including substantive, company-specific risk factors in financial reports is part of a good compliance program and of being a good corporate citizen.
After updating risk factors and safe-harbor disclaimers, what else can firms do?
They shouldn’t forget to identify statements as forward-looking. Many include examples of words that signal predictions in their safe-harbor disclaimers. Consistently doing this in both oral and written statements is useful.
If new risks arise, they should be included in a meaningful way. That could mean listing them in the company’s 10Q or perhaps even in an 8K, depending on circumstances. In today’s economic environment, some companies face risks they couldn’t have imagined a year or two ago: goodwill impairment, loss of S3 shelf registration eligibility, debt defaults or even de-listing. It may be uncomfortable to explore worst-case scenarios, but companies need to disclose important risks.